QE may provide a forgotten backstop

Mining has been the worst performing sector this year as the market waits for a catalyst to emerge in the new year that will prompt a rerating of the industry.

However, this catalyst may not necessarily come in the shape of a resolution to the complex European crisis or an acceleration of the Chinese economy but the hint of a third round of quantitative easing, or QE3, by the US Federal Reserve.

While it is hard to quantify the direct impact of QE on asset prices, experts have been left with little doubt that the US program to print money to buy select types of assets, such as US government bonds, had led to the broad based buying of risk assets that included commodities.

In the nine months following the announcement by the Fed of the first round of QE in December 2008, the CRB/Reuters Spot Metals Index had surged around 70 per cent while the S&P/ASX 200 Resources Index gained over 14 per cent.

The metals index jumped a further 27 per cent and the top 200 resources stock index added 17 per cent nine months after the Fed chairman,
Ben Bernanke
, hinted at QE2 during the annual Jackson Hole meeting in 2010.

There is considerable debate about whether the Fed would embark on QE3 given that its economy appears to be making a slow but steady recovery following the latest string of positive economic data, but this backstop is an important factor that the market has largely forgotten about.

If European leaders appear to be close to resolving the debt crisis gripping the region, commodity prices and mining stocks will do well. If the contagion continues to spread, the Fed is likely to seriously consider another round of QE.

Barring an serious unexpected event, such as the implosion of the Chinese economy, both outcomes could trigger a rebound in mining stocks, particularly since so much bad news is priced into the market.

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“The risks are more to the upside than to the downside [for commodity prices]," said the managing director of Lime Street Capital, Stephen Bartrop. “Our suspicions are that the first quarter or first half of next year will be better than what people think."

Morgan Stanley also suspects that gold prices will rebound when the Fed adopts a new round of quantitative easing in the first half of next year.

The fall in the gold price from its record high over $US1900 an ounce and its inability to attract buying interest in recent weeks despite the escalating European crisis has further soured the mood towards mining stocks. The S&P/ASX 200 Resources Index shed nearly a quarter of its value this year.

To put the loss in context, that is even worse than the embattled consumer discretionary sector, which lost around 20 per cent of its value over the period.

While there are reasons to believe that sentiment towards mining stocks will turn over the next few months, miners are better placed to outperform are those that are generating healthy returns even in this depressed market.

These include gold, copper and coal producers as most, if not all, industry players are still making robust margins at current spot prices for their respective commodities.